Did you know that this time of year is great for tax planning? For me, back-to-school time is just as much the start of a new year as January 1st. With three kids in school, I can finally catch up on some things!
Previously, I shared how to calculate (and decrease!) your marginal tax rate. Your marginal rate is essentially a forward-looking number that shows you how additional income would be taxed.
Your effective tax rate requires a similar, but slightly different calculation. It also serves a little bit different purpose.
The Textbook Definition of Effective Tax Rate
So, then what is your effective tax rate? Well, the book definition of the effective tax rate is simply the ratio of your total tax after credits, divided by your income. This rate is always lower than your marginal tax rate because of the progressive tax system in the U.S. Most tax software uses federal taxable income as the income number for the calculation, but it can vary.
Effective Tax Rate = Total Tax After Credits / Federal Taxable Income
For example, the effective tax rate for someone with a total tax of $26,349 and a taxable income of $158,750 would have an effective tax rate of 16.60%.
There’s a major limitation with this calculation of your effective tax rate: it’s really basically useless for most planning purposes. Yep, it’s true. It’s not going to help you to figure out how much more you’ll pay in income tax with extra income (that’s the marginal rate you’ll need, and in this example it’s 22%). It won’t help you to see how much you’ve been able to decrease your tax with effective tax planning, because it starts with taxable income. And, taxable income is already the result of deferring or excluding income and increasing deductions.
And due to the new tax laws that came into effect for 2018, comparing your 2017 tax rate to 2018 isn’t especially useful either. You probably don’t even have the same amount of income, which makes it even less useful.
Note: there is one way that looking at your effective income tax would be fairly useful and that would be comparing the decrease in your effective tax rate by having most of your income be from qualified dividends and long-term capital gains, which are taxed at preferential rates.
I prefer an alternate calculation of effective tax rate that I refer to as the gross effective tax rate.
What is the Gross Effective Tax Rate?
Instead of calculating the effective tax rate using taxable income or another calculation of income on the tax return, I find it beneficial to use total gross income. That’s what I used when I calculated how much I’m really paying in taxes.
Gross Effective Tax Rate = Total Tax After Credits / Gross Income
To calculate gross income I personally include gross salary, employer contributions to 401(k) and HSA accounts (only the portion of HSA money that I will allow to grow instead of being spent on current medical expenses), investment income, net real estate income and net business income. Note that these last two net numbers would be the profit, not gross income due to the nature of these activities.
I would not include in income funds from the sale of depreciable assets, such as if you sell a car or personal items for less than you initially paid. It’s also optional whether you want to include things like credit card rewards.
If you use my budget categories (free download) or budget/expense tracking template (not free, but it’s worth it!), you would include the following totals in your gross income:
- Gross salaries/wages
- Overtime Pay/Other (wage) Income
- Interest Income (checking)
- Interest Income (savings)
- Dividend Income (brokerage)
- Business income (net profit)
- Rental properties (net profit)
In addition, you should also include net gains from sales of investments (such as stocks, bonds, real estate, etc.). The gain is calculated by taking the proceeds and subtracting your cost basis.
Following up with our previous example (which is the same one used in the marginal tax rate blog post), the gross income in this example is calculated by adding back the following to taxable income:
- $18,500 401K contributions (tax-deferred)
- $9,250 employer 401K match (tax-deferred)
- $4,250 medical & dental insurance premiums (not taxable)
- $1,500 HSA contributions (not taxable, if used for medical expenses)
- $5,500 IRA contribution (tax-deferred)
- $24,000 standard deduction against taxable income (not taxable)
When added to $158,750 of taxable income, this totals $221,750 gross income (note that this can also be calculated by taking a $205,500 gross salary, adding the $9,250 employer match and $7,000 of investment-related income).
The effective tax rate is calculated by taking the $26,349 tax and dividing it by $221,750 gross income, which is 11.88%.
The chart below shows a comparison of gross income, taxable income and total taxes. See that blue area? That’s $63,000 of income that is either completely sheltered from taxes, or deferred to a later date.
And a quick comparison of the different rates:
So, Why Spend the Time to Calculate This?
If you want to know just exactly what percentage of your hard-earned money you pay in taxes, this is the key ratio you’ll need to know. Of course, this only reflects federal income tax, but you can do the very same calculation with your state taxes as well. Simply take your state tax liability after credits divided by the same gross income number.
Using gross income to calculate your effective tax rate provides a better picture of the effectiveness of your tax planning. It can reflect the significant tax benefits like:
- contributing to retirement accounts such as a 401(k) accounts and IRA’s
- receiving income from tax-free investments such as municipal bonds
- taking advantage of tax deductions (such as charitable, HSA contributions, etc.)
In addition, you can compare your effective tax rate between tax years. This is even helpful to see the change in your taxes based on the new tax laws in effect for 2018.
This ratio can also help you to estimate taxes for future years (such as retirement years) if you think you’ll have a similar tax situation from year to year.
How To Decrease Your Effective Tax Rate
Your savings rate and your effective tax rate are inversely related. While you certainly want your savings rate to increase, you want your effective tax rate to decrease (and a higher savings rate often creates that result, since contributing to pre-tax accounts is usually involved).
Some ideas to consider include:
- Contribute more money to tax-advantaged accounts such as 401(k) or other qualified retirement plans and traditional IRA accounts
- Start a side hustle to be able to be able to increase pre-tax money to a solo 401(k), SEP or SIMPLE plan
- Consider starting a business to be able to take advantage of the new qualified business income deduction as well as being able to deduct other expenses that you otherwise wouldn’t qualify for (such as a portion of your internet, phone, and home expenses if you have a qualified home office)
- Increase your qualified dividend and long-term capital gain income by saving and investing more of your income, as these types of income have preferential tax rates that are much lower than for earned income
- Bunch your deductions to be able to increase your ability to itemize deductions in certain years (this may be harder for many due to the new tax reform)
- Have a qualified tax professional prepare your returns just for even one year so that they can make sure you’re taking advantage of all the deductions you’re entitled to
If you’ve never calculated your effective tax rate before, you definitely should!
Just as tracking your savings rate and net worth help you in determining your financial progress, the gross effective tax rate helps you to monitor your progress in your tax planning efforts.